Amidst Electricity Market Turmoil, Retailers Exit To Cut Cash Losses But Sit On A Pile of Futures Profits

Biden's catastrophic energy policy turned US from a net exporter to importer of oil and caused oil prices to increase steadily since he entered the White House. Recently, he had to beg OPEC to increase production. With OPEC's refusal to oblige when they met this Monday 15 October, oil prices responded immediately by shooting up to US$82/b Friday 17 October, its highest since Sep 2014. This is a steep over-run of the US$74/b average for Q4 the EIA (US Energy Information Admin) had previously forecasted.

This oil price hike is causing turmoil in our retail electricity market. Several retailers have either exited or going to exit the market. I shall try to explain here briefly how the tariff is derived, how gencos offer their auction prices, why the retail model is not sustainable, why retailers throw in the towel in this oil price hike crisis, and why retailers are not exactly loosing their pants.

Before I proceed, I like to get 2 constant gripes by the public out of the way:
(1). The government always use increase in oil prices as an excuse to raise tariff but our power generation is 90% from gas plants. The reason is, gas is priced differently depending on which region in the world. In our part of the world, gas is indexed to oil price. Hence oil price increase means gas price increase.
(2). Singapore Power squeezes the public with higher tariff but makes S$1 billion profit annually. Actually, SP purchases at the same wholesale price as all retailers. It makes zero profit from sales of electricity because all their sales to non-contestable consumers are fully hedged. The billion profits is from operations in transmission/distribution and overseas' subsidiaries. More importantly, Singapore electricity is not a cost-based regulated regime, it is market-driven prices. Consumers have freedom of choice to buy from any provider.

There are 3 basic terms that need to be understood first.

How SP price the tariff :

Tariff comprises of energy cost and a fixed cost (transmission cost, other admin cost). We concern ourselves only with the energy cost here. SP makes a forecast of the energy cost on a quarterly basis. This is computed as a new power generation company coming into the market. This cost of production comprises of a variable cost (mostly fuel) and fixed cost (capital charge or plant depreciation). This is computed for a certain desired load (output quantity). The production cost that is obtained this way is known as the LRMC (long run marginal cost). Marginal cost is the cost required to produce one more unit of the goods (kwh of electricity). To this LRMC is added a reasonable operating cost (admin, sales, etc) and ROI to arrive at the energy cost for the tariff.

How gencos (power generation companies) price their electricity:

Gencos look at production cost only at the variable composition. Fixed cost is ignored as they are a sunk cost. This is the SRMC (short run marginal cost). In the short run, Gencos can continue to keep the plant running as long as the price is not below the SRMC. Of course in the long run, this is not sustainable. Gencos price themselves using the SRMC plus a markup to cover fixed cost of production, operating cost, and ROI. How much to markup depends on the competition.

USEP (Uniform Singapore Energy Price):

Gencos sell their electricity to the WEM (Wholesale Electricity Market) via auction every 30 minutes. The average price of all the successful bid for each 30 min is the USEP (Uniform Singapore Electricity Price). There are some zonal fees to be paid to gencos depending on where their load enters the grid. All participants (retailers, SP, big corporations that buy direct) buy at the WEM at the same WEP (wholesale energy price), which is the USEP + a small admin fee.

A fourth term is vesting contracts. This is rather more complicated, so in the interest of keeping things simple here, I have omitted this.

Fig.1. Where power generation capacity is equal to demand, the SRMC would be close to LRMC. That is, Gencos' offered price will be close to the energy cost of the tariff. The USEP is not a straight line due to oil price volatility in every 30 minute auction..

Fig.2. When there is over capacity of power generation, the SRMC falls below the LRMC. With over capacity, gencos compete at lower prices in order to win despatch for their plants.

This means gencos are selling to the wholesale market at prices below the tariff energy cost. It means gencos are selling with razor thin ROI or making losses.

All retailers purchase electricity at the same wholesale price (USEP + a small admin charge). The yellow band represents the space that retailers can offer discounts to tariff. In earlier years, this was as high as 30% discounts.  This explains the reason why retailers can sell below tariff.

Singapore has a huge over-capacity in the market. As a result, gencos have been struggling with losses. In the long term, a status of SRMC curve below the LRMC is not sustainable for the market. The power generation industry survives on the belief the economy will grow the demand soon and absorb the over-capacity. For years, consumers have actually benefited on suppressed prices without understanding or appreciation.

Fig.3. When power generation is under-capacity, that is, when demand exceeds supply, the USEP will be higher than the tariff energy cost.

With under-capacity, gencos have the market power to offer higher prices at the wholesale market auction. This is the downside of a market-driven model vs a regulated price model. 

Under this scenario, the retail pricing model becomes unsustainable as retailers will be pricing themselves higher than tariff.

On Monday 15 October when OPEC decided not to increase production, all hell broke loose in the energy markets.

We are now in the situation as depicted in Fig.3. where the USEP is way above the LRMC. At this state, the retail pricing model collapses. The current situation is not caused by demand outstripping supply, but by the steep rise of fuel that pushed the SRMC up.

In such a situation, retail prices are way above tariff. Ordinarily, retailers would not be able to acquire new accounts. As the price is too volatile, many retailers have stopped quoting. Retail arms of Gencos, I suspect, will take on accounts only to the extent of their generation capacity.

Retailers sing 'Don't Cry For Me Argentina' :

A retailer who has taken the high risk of not hedging his position in the electricity futures market would be terribly crushed by now. But I suspect this is not the case. Practically all of them hedged. The market is simply too volatile not to hedge. However, even if they are hedged, the cashflow pressure weighs extremely heavy on they. Retailers purchase at the wholesale spot market and pay upfront but collect from their customers one week after a month end. With spot prices doubling since Monday, their immediate cash outflow has doubled. They are forced to exit the market due to liquidity crunch, not profitability if they are adequately hedged.

Retailers are always short on the cash side because they had contracted to sell to their customers electricity which they do not have. And now, as wholesale spot prices hiked, their cost have soared whilst revenue remain unchanged. Thus retailers are making severe cash losses at the moment.

On the other hand, retailers who hedged are long in the futures side. Since these futures contracts were purchased earlier, and with spot prices doubling, retailers are 'in the money'. They are making tremendous profits in the futures side now, but it's all on paper. 

So if retailers exit the market now and transfer accounts to SP as the lender of last resort, they cut the cash losses but still hold on to tremendous profits in the futures contracts. Let SP carry the baby, and sit on a pile of paper profits on the future contracts. What actual profits the futures contract will bring depends on the strike price at maturity dates. However, carrying a long futures position and riding into an oil price scenario of US$82/b average in the short term, it's a damn good place to be in. So it's a case of don't cry for me Argentina.

SP as supplier of last resort:

Retailers that exit transfer all accounts back to SP at prevailing tariff rates. SP steps in as supplier of last resort.This was what happened the previous occasion when Red Dot exit the market. But this time, SP has to shoulder 2 considerable burdens. (1) The volume is huge as there are several retailers heading for the door at the same time. (2) Prevailing tariff energy cost and wholesale spot price gap is way too big. USEP is now almost double the tariff. For SP to take over these accounts at tariff rate will mean unimaginable losses.As it is, I heard SP is not accepting accounts beyond a certain kwh usage.

The customers of the retailers who exit are now caught in a bind. Their existing contracts which have not run out are at half the price today. Not only will they see their energy cost double, as of this writing, many are in a jam as they are unable to find a a provider willing to accept new accounts.

The solution?

What the industry is facing is a black swan event for which the supplier of last resort safety net was not designed to cover.

All top guns are meeting round-the-clock to sort out the crisis, no doubt about it. How will this be resolved? This is essentially a retailer liquidity crisis, the solution for which is credit facilities.

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